Have central clearing policies worsened ‘too big to fail’?

Editor's Note: The following commentary originally appeared here in slightly different form.

Twice a year, the Bank for International Settlements releases global aggregate data regarding the derivatives markets. It provides an often illuminating window into broad trends in the derivatives markets. The data sets constitute some of the original “big data” given the volume and value of the contracts involved.

The most recent round of data was released in time for various international regulatory policy meetings planned between now and June, including meetings of the Financial Stability Board and the Basel Committee.

The data was released as debate rages over whether or not the post-crisis reform initiatives have stifled economic growth and whether certain reforms should even be implemented. A range of policymakers from France, Japan and the United States have all recently signaled an interest in reconsidering the scale, scope and substance of remaining reform initiatives. The FSB has been tasked by the G-20 to undertake a comprehensive review. Recently, the U.S. House Financial Services Committee passed the Financial Choice Act, which is designed to roll back many of the post-crisis reforms.

One of the signature reforms following the crisis focused on the derivatives markets. The vast majority of derivatives market activity occurs in the interest rate market. Consequently, this article looks at BIS data regarding those markets. The remaining market segments (equity derivatives, foreign exchange derivatives, commodities derivatives) are much smaller markets which include comparable data trends to the interest rate segment. Here are some key questions and other considerations arising from the BIS data release.

Did the reforms on the central counterparties work?

One key reform following the financial crisis involved efforts to shift transactions away from bilateral deals towards transactions effected with a central counterparty. The policy imperative was to ensure that documentation and liquid resources served as a quality check on transactions. Entry requirements (“initial margin”) and ongoing maintenance requirements set in relation to transaction volumes (“variation margin”) at the clearinghouse would enhance systemic stability by ensuring that traders had sufficient liquid resources to support their market activity.

Implementation efforts designed to move away from “over the counter” (OTC) markets and towards central clearing have been slow and incomplete globally. The European Union and the United States have adopted different technical implementation measures. They remain at loggerheads over this divergence, but that is another story.

Does the data indicate whether or not the reforms achieved their intended goal? The answer is: Yes and no.

The BIS indicates that central clearing for credit default swaps (CDS) jumped from 37% of notional amounts outstanding at the end of June 2016 to 44% at the end of December. It also notes that central clearing for OTC interest rate derivatives markets “was more or less unchanged at 76%.” But the amount of reporting dealers has declined. This data suggests strongly that increased clearing has occurred apparently at the expense of reporting dealers.

This mirrors a parallel debate in the financial services industry regarding whether post-crisis reforms have adversely impacted market liquidity by driving market-makers out of the trading business.

But the BIS data also indicates that clearing activity seems to have had no impact on market activity by “other financial institutions.” According to the data, activity by “other financial institutions” grew during the early days of the financial crisis. These entities have been the majority participants in the market ever since, with their share of transactions only dropping once after central clearing became operational.

Definition of 'other financial institutions'

If reporting dealers have effectively exited the market, who are these “other financial institutions”? The BIS Glossary does not tell us, exactly.

It defines “financial institution” as “financial corporation.” In turn, financial corporation is defined as an “entity that is principally engaged in providing financial services, such as financial intermediation, financial risk management or liquidity transformation” and includes “central banks, banks and non-bank financial corporations.”

Based on these definitions, it would seem that the vast majority of interest rate derivatives trading since the crisis has involved counterparties from central banks, insurance companies, pension funds, asset managers and possibly sovereign wealth funds. It is unclear how state-owned financial institutions are treated based on these definitions as well.

This is not exactly what policymakers had in mind when they set out to make the financial system safer by creating central clearinghouses.

Don’t jump to conclusions yet

This story is not yet over. The first two reporting periods (from 2016) indicate that central clearing is slowly taking market share from “other financial institutions.” These entities may yet fulfill their intended function of providing the market with a central location where cash and collateral can secure trading activity, thus decreasing volatility and systemic risk.

In the process, however, government reformers will have created nonbank entities in the financial markets that are indeed “too big to fail.” This risk is not lost on policymakers.